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A retail turnaround with asset backing, and a catalyst

A struggling retailer with a large amount of fixed real estate assets; a few companies come to mind like JC Penny and Sears Holdings. While both of those companies fit the stereotype, the company I want to look at in this post is Kirkcaldie & Stains, a New Zealand retailer.

Kirkcaldie & Stains (KRK.New Zealand) is a retailer (department store) that has been in business for 150 years in Wellington, New Zealand. The company originally owned the building they were located in, but over time sold it off. The company doesn't actually own the building that holds their flagship retail store, and in 2001 to rectify the situation purchased the building adjacent to themselves. The company breaks results into two segments, retail and property. Both have struggled for the past few years, but there are signs things are turning around.

I'm not usually a fan of turnarounds, there are too many variables that need to come together for an investment to work out. For a retail turnaround to work the retailer either needs to reduce expenses if they're bloated, or more likely bring in new brands and increase store traffic. For Kirks, who is experiencing declining sales volume, cutting expenses alone won't bring the company to profitability.

In terms of a retail turnaround the company has a lot of low hanging fruit changes that they are implementing in an effort to gain customers. Up until this past year the company didn't have an online store, they just recently started selling online. They have also started to carry well known international fashion brands. In an effort to reduce costs the company moved their back office operations to a lower rent area nearby. With all of these changes it's hard to know if any one of them will help change the company's sale momentum. If they do it would be a boon to investors, but if they don't the investment story isn't destroyed. The story of Kirks is more of an asset story than a retail turnaround story.

As I mentioned above the company owns Harbor Centre which is located in the prime business district of Wellington. The company purchased the building in 2001 and holds the building on their balance sheet at historical cost. Typically when a company has an asset worth far more than its balance sheet value the asset is considered hidden. Harbor Centre's value isn't hidden in the slightest. The company has the building valued yearly and includes the latest appraisal value in the annual report. As of the annual report the building had a carrying value of $26.8m but was appraised at $46.5m.

I put together a small summary adjusted balance sheet to show the difference between reported book value, and appraised book value.

The adjusted balance sheet clearly shows that the company is trading at book value for the property company alone. In investor parlance you buy a building and get a retailer thrown in for "free". It's worth noting this isn't an empty building, they do have tenants paying rent, vacancy is 9.6%.

At this point in the post the Kirks story is no different than what someone might write about Sears or JC Penny or any other asset heavy struggling retailer. The difference is that Kirks has been working to monetize their Harbor Centre property.

The company put Harbor Centre on the market and received a bid last fall. The bidder wasn't announced but took their time to complete due diligence. When the sale of the building was announced shares ran up to $3.20, which is about 50% higher than where they trade now. Once investors realized the company might do something with their undervalued asset they suddenly started to price it closer to reality. Unfortunately the bidder on the building fell through, and along with it the share price collapsed.

The company engaged a consultant to advise them on how they could split apart the companies. Kirks will spin-off the Harbor Centre property and the associated management company into a separately listed company this year.

A lot of readers might be wondering if the company is going to split off their property group, then why is the company so cheap? The answer is located in the results section of the annual report, the company's returns have been poor to say the least. On a headline level it's understandable to see why investors are scared and fleeing the stock.

At the retail level the company's sales have been in decline for the last five years, and investors have apparently lost hope. The company's property division has provided support for earnings up until the New Zealand earthquake. Since the earthquake the property division has had to invest significant amounts into earthquake strengthening. They have also invested in an expensive remodeling effort to attract a new client. While many one time costs will roll off for the property division soon they have also been hit with much higher insurance rates, most likely in connection with the earthquake.

Even with the poor earnings there significant value resides in the Kirks property division. If the company were to split today I would consider the stock's current price close to fair value for the property division alone. That means that either the retailer is worth nothing, which is a possibility, or it's a gross mis-pricing. Usually what sinks retail turnarounds is the company isn't able to right the ship quickly and takes on debt to finance operations. The company's debt starts small but grows with deteriorating conditions eventually pushing the struggling retailer into bankruptcy. Kirks has debt on their balance sheet, but it's all associated with the property division. The Kirks retail division has no associated debt, which gives the company additional runway to recover.

7 comments:

Horbach Baumarkt, a high quality DIY retailer in Germany with family as main owner, is valued similarly i.e. no value to operations (m.cap €780m., real estate ~700m., net cash). It is growing so no need to "turn around". It doesn't have a catalyst, though.

Property valuations are more risky as they are these mega stores outside city centers. I think the stock is worth at least €40-50/share, while the market price is currently around €24 (lowish liquidity for some reason even though it is a big company).

Love following the blog, thanks for your work. This is a classic off balance sheet asset value situation.

The retail business probably has zero equity value, if you adjust assets such as cash, inventory and PPE to more conservative liquidations values (i.e. ~50% discounts). Last seasons stock, old point of sale systems etc. "Fowci's" spread sheet above is useful here.

But its all about the property asset/business value. The trouble is, not only is debt to be attributed to the property, but renovations, increased insurance, vacancy, administrative and tax or spin-off cash outflows must be taken off the 100% "independent" valuation. Some of this has been factored into the valuation one would expect, but on the other hand, the valuation may well have factored in the new lease signed as well. Although the new lease was signed after the valuation, it is normal for property valuations to account for rental yield "at market" notwithstanding that the lease is currently not signed. Its a bit like buying a residential house for investment, with it currently not being rented, but an broker (agent) or investor knowing that a particular rent is quite achievable, if even if a tenant is not there at that moment.

The problem is the independent valuation.

If 100% value can be attributed to the HCC property, then a share equity value of well over NZD 3.00 is to be expected, regardless of how it is realised (sale, spin-off etc). But there is huge asset leverage in this: If only 80% of the independent valuation can be attributed at market, then the share equity value is NZ 2.00 and possibly down to NZ 1.50. 80% may or may not be a conservative mark down. If the mark down was 80% and the equity per share still showed a break even or profit then you might have a think about buying it. But that does not seem to be the case here.

"Independent" property valuations are notorious, positively and negatively. The methodology used, management influence involved, assumptions permitted to be used etc can be either conservative or fantastic, while the valuation can still be "fair, reasonable and independent". I bet the ANZ bank valuation on the property is very different.

There is only one way to find any margin of safety here: GET A COPY OF THE VALUATION. If you can't understand how the valuation was complied (regardless of the reputability of the valuer)then its pure speculation.